VG Energy and the Economics of Biofuels

by Stephen_Waite on March 25, 2011

In our ini­ti­a­tion of cov­er­age note on Viral Genet­ics (VRAL) back in Feb­ru­ary, we noted that the com­pany cre­ated a majority-owned sub­sidiary called VG Energy to develop algae-based nutri­ent and energy tech­nol­ogy. This tech­nol­ogy can be used to pro­duce diesel and jet fuel sub­sti­tutes for tra­di­tional petro­leum fuels. It was derived from a dis­cov­ery that came out of Viral Genet­ics’ research in can­cer treatment.

Lab­o­ra­tory exper­i­ments at Viral con­ducted by Dr. Karen Newell-Rogers and her team show that mol­e­cules which can dis­rupt the burn­ing of fats (lipids) in tumor cells can also encour­age algae to accu­mu­late and secrete fats. In the lab, Dr. Newell-Rogers’ tech­nique increased lipid pro­duc­tion by over 300 per­cent. This is a poten­tially pio­neer­ing dis­cov­ery that could rad­i­cally alter the eco­nom­ics of future bio­fuel production.

Another sig­nif­i­cant find­ing by Dr. Newell-Rogers is that with VG Energy’s tech­nique, the fat is stored out­side the wall of the cells, thereby mak­ing it pos­si­ble to extract it with­out killing the algae. With con­ven­tional tech­nol­ogy, the algae can­not be reused. This find­ing opens up the pos­si­bil­ity that oil can be sep­a­rated and recov­ered from the algae in a non-destructive way, which has the poten­tial to sig­nif­i­cantly reduce the cost of pro­duc­tion and bring the cost into line with con­ven­tional fos­sil fuels.

At the time of pub­li­ca­tion of our research note, there was very lit­tle infor­ma­tion on VG Energy and no way to gauge the value of the com­pany in its present embry­onic stage of devel­op­ment. We were aware that VG Energy was dis­cussing the tech­nol­ogy with var­i­ous bio­fuel experts, and that some of those who exam­ined it viewed it as a poten­tially impor­tant and sig­nif­i­cant devel­op­ment in algae-based biofuels.

Dr. Sheehan’s research is the first attempt we’ve seen to eval­u­ate VG Energy’s tech­nol­ogy in a rig­or­ous man­ner. He eval­u­ated sev­eral sce­nar­ios, including:

• Enhanced pro­duc­tion of higher value oils, such as omega-3-fatty acids, in open pond algae systems

• Enhanced pro­duc­tion of fats for oil pro­duced as a feed­stock for bio­fu­els in open pond algae systems

• Sce­nar­ios that take advan­tage of observed oil secre­tion in VG-treated algae to per­mit non-destructive recov­ery of oil and recy­clng of algae to ponds.

The enhanced pro­duc­tion sce­nar­ios in Dr. Sheehan’s report are com­pared with sce­nar­ios based on val­ues for cur­rently achiev­able pro­duc­tiv­ity lev­els of algal open pond sys­tems that are found in the sci­en­tific lit­er­a­ture. Sheehan’s sce­nar­ios show that VG Energy’s dis­cov­ery could trans­form algae tech­nol­ogy from being a neg­a­tive rate of return propo­si­tion to being an attrac­tive and prof­itable ven­ture. He notes that the intro­duc­tion of VG Energy’s addi­tives offers the abil­ity to knock down the cost of algal oil pro­duc­tion by almost a fac­tor of ten as a result of pro­duc­tiv­ity improvements.

Shee­han also notes that if oil secre­tion cur­rently observed in VG Energy’s lab can be fully demon­strated in larger scale growth sys­tems, there is poten­tial for fur­ther decreas­ing costs by another fac­tor of roughly two. This would rep­re­sent a dra­matic shift in the eco­nom­ics of algae tech­nol­ogy and would, as Shee­han observers, be game-changing.

Sheehan’s eco­nomic analy­ses, though pre­lim­i­nary, illus­trate the promise and poten­tial of VG Energy’s tech­nol­ogy at a time when there is grow­ing investor inter­est in algae bio­fuel tech­nol­ogy. Sev­eral syn­thetic biol­ogy com­pa­nies have came to mar­ket over the past year, includ­ing Amyris Biotech­nolo­gies (AMRS) and Gevo (GEVO). Ear­lier this month, Solazyme filed an S-1 and plans to raise $100 mil­lion in a pub­lic offering.

Solazyme has a unique process for cre­at­ing fuel from algae. It grows its algae in dark pools and feeds them sugar. Most con­ven­tional algae processes use open sun­lit ponds and rely on pho­to­syn­the­sis to pro­duce the sugar needed to get the algae to pro­duce oil. Solazyme feeds sugar directly to the algae. The oil pro­duced by Solayzme’s sugar-fed algae is then refined into usable fuel. The U.S. Navy is a big cus­tomer of Solayzme’s bio­fuel today, and other com­pa­nies are eval­u­at­ing it for com­mer­cial use.

Another emerg­ing bioen­ergy com­pany that is on our radar screen is Syn­thetic Genomics, which is backed by Exxon­Mo­bil. Syn­thetic Genomics was founded by biotech pio­neer Craig Ven­ter. Ven­ter led the pri­vately financed ver­sion of the Human Genome Project and is one of the world’s lead­ing biotech vision­ar­ies. Syn­thetic Genomics appears to be using a more con­ven­tional open sun­lit pond approach to pro­duc­ing fuel. That said, Venter’s vision and exper­tise in genomics and biol­ogy, cou­pled with the finan­cial back­ing of the world’s largest energy com­pany, makes Syn­thetic Genomics a com­pany to watch as a source of future bio­fuel innovation.

As we noted, there is grow­ing investor inter­est in bio­fuel tech­nol­ogy. But there is also a good deal of skep­ti­cism among ven­ture cap­i­tal­ists as well as in the aca­d­e­mic com­mu­nity. Ear­lier this year we spoke with Pro­fes­sor James Richard­son, an agri­cul­tural eco­nom­ics pro­fes­sor at Texas A&M. Pro­fes­sor Richard­son has eval­u­ated the eco­nomic fea­si­bil­ity of many con­ven­tional algae bio­fuel tech­nolo­gies in con­junc­tion with the work he is doing with the National Alliance for Advanced Bio­fu­els and Bio­prod­ucts con­sor­tium. The NAABB is study­ing over 575 strains of algae to deter­mine which is best for lipid production.

Pro­fes­sor Richard­son and his research team at Texas A&M have built Monte Carlo sta­tis­ti­cal mod­els and looked at 10-year sim­u­la­tions of many algae-based bio­fuel tech­nolo­gies. Their research shows that most bio­fuel tech­nol­ogy has neg­a­tive return pro­files and is unlikely to be prof­itable. Inter­est­ingly, Pro­fes­sor Richard­son has done a pre­lim­i­nary eval­u­a­tion of VG Energy’s novel bio­fuel tech­nol­ogy and told us that it has a bet­ter than even odds of pro­duc­ing pos­i­tive investor returns.

While fur­ther analy­sis needs to be done before draw­ing defin­i­tive con­clu­sions on VG Energy’s bio­fuel tech­nol­ogy, the pre­lim­i­nary results of both Dr. Shee­han and Pro­fes­sor Richard­son are encouraging.

At this junc­ture, it is still dif­fi­cult to say how big an impact VG Energy will have on the value of its par­ent, Viral Genet­ics. We think the best way to view VG Energy today is as a free out-of-the-money call option on Viral Genet­ics. Although Viral Genet­ics remains in devel­op­ment stages and trades today at just $0.046 per share, this com­pares to our base case IV esti­mate on Viral Genet­ics of $0.49. That said, there is clearly more poten­tial for value cre­ation for Viral Genet­ics in the future with a suc­cess­ful launch and prof­itable build-out of VG Energy.

[Dis­claimer: Viral Genet­ics is a cor­po­rate research client of Research 2.0. We received com­pen­sa­tion in exchange for pro­vid­ing on-going inde­pen­dent research cov­er­age. We main­tain our own research process, exer­cise full edi­to­r­ial con­trol of all pub­lished con­tent, and apply the same stan­dards to Viral Genet­ics as we do to all com­pa­nies we fol­low. Research 2.0 employ­ees are gov­erned by fair deal­ing and “client first” rules that are sim­i­lar to com­pli­ance rules at broker/dealers and banks. For addi­tional infor­ma­tion about our spon­sored research pro­gram, please visit our spon­sored cov­er­age page on the web­site. For addi­tional infor­ma­tion about Research 2.0 dis­claimers, dis­clo­sures and employee poli­cies please visit our legal page.]

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